Description

Apologies if the trading price used is not executable, as this should have been posted yesterday before earnings, and I won’t be around during the trading day today. I listed it at a price 10% above the close yesterday to try and mitigate that possibility. I did add one or two comments based on the earnings call.

I am highlighting the opportunity in Avalara. It may not offer the highest upside of any potential stock, but I believe it offers a high level of certainty and predictability fundamentally. A combination of growth stock despair and e-commerce worries have driven the stock down considerably. It’s a great company with solid prospects and limited floating debt (they have $900mln in convertible debt, fixed at 0.25%, due 2026, convertible at around $240 per share, which constitutes virtually all of their non-WC liabilities). This is covered by $1.4bln in cash – they are slightly cashflow positive on an operating basis).

In late 2020, natey1015 posted a write-up of Avalara’s business – it’s very good and comprehensive. So, I will not rehash too much of that write-up, and I would suggest reading that if you want more information about the business itself. Here’s the link:

https://valueinvestorsclub.com/idea/AVALARA_INC/8568964125#description

The reality is that not much has changed in this company since that write-up. I’ve been vocal in my belief that the last few months offer great opportunities to acquire companies like this that will produce huge returns over a medium term timeframe.

Core idea

There is a simple extant business thesis underlying this business which applied at the time of that write-up and still does

1.       They have a dominant technology and competitive position in their core US middle market segment, with the ability to compound revenue 20% for a long time from this segment. They are a consistent share taker here. Avalara has remarkable low gross churn of around 5% considering the business segment they serve, consistent with top quartile large enterprise facing software. Businesses in this segment likely carry an aggregate failure rate close to Avalara's churn rate.

2.       Significant but challenging opportunities to build valuable businesses in enterprise and internationally that could be multiple times the size of their US middle market business.

3.       Their software is high ROI from a direct cost replacement point of view, reduces potential liability, and every year increases in importance in a digitalising economy. In this environment, offering cost savings is a more resilient software business model than offering revenue generation.

4.       E-commerce payments infrastructure is relatively fragmented, and most of these players do not want to cross integrate, but are happy to do so with Avalara who do not compete with their core business. Customers rarely use a single solution for their payments infrastructure, but they want their tax software to work across all of their providers. Therefore, vertical integration of this business by a large payments infrastructure provider is unlikely to work.

5.       In a budgetary crunch, state governments are highly incentivised to crack down on sales tax avoidance as it is a high percentage of state revenue in many cases. Back then, covid caused budget concerns. Now it’s just general macro and potential federal shortfalls causing budget concerns.

6.       This type of software business should over time produce high gaap operating margins, although they have been investing in their product and market share which currently depresses margins. They are selling a high ROI product on a primarily non-transactional basis, have low churn and a highly dominant market position, relatively large ticket sizes, and are directly needed for businesses to generate revenue (legally run businesses must manage sales tax somehow, it is not an option).

So what aspects of that thesis have changed?

1.       Valuation is far less. The business has grown 50% in size, and the market value of the business is down 50%.

2.       The e-commerce business environment has taken a material downturn, without materially impacting Avalara’s growth rates. Indeed, a less beneficial business environment would increase the importance of cost saving and efficiency tools like Avalara. However, around 50% of their business is tied to overall business volume, rather than a fixed customer payment, so there is some risk on a volume basis if the overall e-commerce industry collapses. I don’t expect that. I merely see the current environment as being mostly created by mean reversion post a huge surge in activity post covid, with of course some negative effects from supply chain and inflation issues in the wider economy.

3.       Based on what I’ve heard and their public comments, I believe Avalara will change their financial approach in response to their current environment, and there will be a quicker margin ramp than would have been anticipated 18 months ago. They will do an analyst day later this year at which point they will lay out their plan.

Of these, the first is a basic mathematical fact, and the second is a very broad topic and many facets of it are being widely discussed in relation to many different companies in the market. So probably the third is of more interest to investors in this company to do their own confirmatory diligence.

The key risks

·         Avalara is an unprofitable business in an investment environment where that is not a lot of fun.

·         E-commerce businesses were on a fundraising tear throughout 2020 and 2021, and had huge pull forward in revenue in 2020. Recall for example the Amazon seller roll-ups that raised tons of money (Mohawk/Aterian, BBG, Perch, Thrasio etc.). In mitigation, Avalara did not see huge acceleration in revenue growth over this period from covid related e-commerce pull forward and investment. They saw 29% organic growth in each of 2020 and 2021. This compares to a mid 20s for 2022 (assuming modest uplift from their guide), and low 30s for 2019. This is not a business that looks like a covid winner set for mean reversion.

·         Payments infrastructure is an industry that has long invited consolidation, which creates the risk of a large player levering their market power to enter the adjacent sales tax business. For example, Stripe has acquired into the SMB sales tax business. Avalara sits in the middle market position, where companies generally use multiple payment providers, require a more complex solution, but lack the business infrastructure to have a sophisticated tax management department.

·         As mentioned, around half their revenue is volume based, which provides more downside exposure to the industry.

Return and downside

These are based on the 77 SP I listed this idea at.

Avalara trades at around 7.5x EV/Sales and 10x EV/GP for 2022. It will grow organically around 25% this year. It is likely to organically compound sales at >20% for some time.

I believe it has terminal operating margin power of >30%. On that basis the stock trades at around 20x its 2022 earning power.

If you assume that terminal operating margin power is 15%, the stock trades at 40x earnings power for many years of 20+% growth.

I think Avalara will hold its multiple at least and compound at >= its sales growth (less dilution) for the next 5-10 years. This implies an IRR of >20%, and closer to 30% including cash generation. Of course, more is certainly possible if sentiment changes.

I have reviewed many mature software businesses and their margin profiles over the years, and this evidence suggests that businesses that have the characteristics described in section 6 of the extant business thesis rarely have gaap operating margins below 30%, and in many cases they can exceed 50%. Therefore, I am confident in my projections of earnings power, and I only see risk to this if I have materially misjudged the quality of the business e.g. if I have misjudged the risk of vertical integration from payments companies. Regardless, I expect the next 12 months to demonstrate at least the 15% level of earnings power at Avalara (from their analyst day and improved spending efficiency in response to the current business environment).

Any unprofitable business carries the risk that it cannot be profitable and that it is simply buying dollars for cents. I am very confident that if Avalara decided to grow in line with GDP that they would generate high margins right now. I also think that would be the wrong decision. I don’t see material fundamental downside to this stock unless you subscribe to that structural unprofitability point of view or believe that the competitive position of Avalara is weak. I don’t think there is a valuation case for fundamental downside. Therefore, I find it difficult to justify a specific price as a fundamental bear case. If it traded at 30, which is of course certainly possible considering the current macro and investment environment uncertainty, I would still say that the downside risk comes from the same problems. If you think Stripe will successfully disrupt the business with a middle market tax solution, it’s probably worth less than 30. If you think it’s structurally unprofitable it’s probably close to a zero. I see both of those as remote possibilities, but of course it is possible I am wrong.

Catalyst

• Change in margin profile at analyst day
• Change in sentiment
• Growth is the catalyst